The purpose of this consultation is to gather stakeholders' views on two specific issues in the area of counterparty credit risk, namely:

Capitalisation of bank exposures to central counterparties (CCPs) and

Treatment of incurred credit valuation adjustments (CVA).

These concepts are explained further on in the memo.

The results of this consultation will feed into the work being done to implement the Basel III reform package, setting the new prudential requirements for banks, into EU law. The European Commission will come forward with proposals before the summer.

Why are these issues important?

The financial crisis highlighted that banks massively underestimated the level of counterparty credit risk associated with over-the-counter (OTC) derivatives. This prompted G20 leaders at the September 2009 Pittsburgh summit to call for more OTC derivatives to be cleared through a Central Counterparty (CCP). They also asked that OTC derivatives that could not be cleared centrally be subjected to higher capital requirements in order to properly reflect the higher risks associated with them.

Following the G20 leaders' call, the Basel Committee on Banking Supervision (BCBS) started to review the regulatory capital treatment for counterparty credit risk. The BCBS identified insufficiencies1 and that CCPs were not widely used to clear derivatives trades. As part of the Basel III reforms, the BCBS has changed the counterparty credit risk regime substantially2.

The new regime will strengthen the capital requirements for counterparty credit exposures arising from institutions’ derivatives, repo and securities financing activities. It will create the right incentives for banks to use CCPs wherever practicable, thus helping reduce systemic risk across the financial system.

in effect helping to reduce systemic risk across the financial system.

How does this relate to other Commission proposals?

The review of the treatment of counterparty credit risk in the CRD forms an integral part of the Commission’s efforts to ensure efficient, safe and sound derivatives markets. It complements the Commission’s other regulatory initiatives in this area, in particular the Regulation on OTC derivatives, central counterparties and trade repositories that was adopted by the Commission last September.3

This Regulation introduces – among others - a clearing obligation for eligible OTC derivatives via CCPs and puts forward stringent rules on prudential, organisational and conduct of business standards for CCPs.

In the consultation document on counterparty credit risk, it is being suggested to base the capital treatment of bank exposures to CCPs on the compliance of the respective CCP with these standards. It is being proposed that the capital requirement for exposures to those CCPs that will meet these standards will be significantly lower than the capital requirement for OTC derivatives4. Consequently, imposing different capital requirements for centrally cleared derivatives and non-centrally cleared derivatives will provide further important incentives for banks (i.e. credit institutions and investment firms) to use CCPs more widely.

Why are we consulting on these two issues specifically?

To ensure we have all the information necessary to be able to finalise the upcoming legislative proposal related to the amendments in the area of counterparty credit risk due before the summer. Between February and April 2010, the Commission services conducted a public consultation on further changes to the Capital Requirements Directive (CRD), which broadly followed the preliminary proposals put forward by the BCBS in December 2009. While the consultation did include preliminary proposals amending the treatment of counterparty credit risk in the Capital Requirements Directive, it did not set out the necessary level of detail on two issues: first, the capitalisation of bank exposures to central counterparties; and second, the treatment of incurred credit valuation adjustments.

On capitalisation of bank exposure, the measures outlined in the consultation broadly follow the preliminary proposals set out in the Basel Committee's consultative document on the same issue published on 20 December 20105. In addition, the Committee is currently preparing an impact assessment of its own proposals. Consequently, the Commission will carefully weigh the outcomes of both consultations and the impact assessment when finalising its legislative proposal.

On incurred credit valuation, the Basel Committee specified the respective treatment of incurred credit valuation adjustments in the final rules published on 16 December 2010. This treatment is, however, subject to a final impact assessment by the Basel Committee, which should be completed in the first quarter of 2011. In finalising the policy line on this issue, and in keeping with the Better Regulation Agenda, the Commission will give due consideration to both the results of the impact assessment and to the consultation responses.

What are OTC derivatives?

A derivative is a financial contract linked to the future value or status of the underlying to which it refers (e.g. the development of interest rates or of a currency value, or the possible bankruptcy of a debtor).

Over-the-Counter (OTC) derivative contracts are not traded on an exchange (for example the London Stock Exchange) but instead privately negotiated between two counterparts (for example a bank and a manufacturer). OTC derivatives account for almost 90% of the derivatives markets. In mid 2010, the notional value of outstanding OTC derivatives was around $583 trillion or €476 trillion. At the same point in time, the notional value of derivatives traded on exchanges was roughly $66 trillion or €54 trillion.

The OTC derivatives market comprises a wide variety of product types across several asset classes (interest rates, credit, equity, foreign exchange (FX) and commodities) with widely differing characteristics and levels of standardisation. OTC derivatives are used in a variety of ways, including for purposes of hedging, investing, and speculating.

What are Central Counterparties (CCPs)?

A CCP is an entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer. A CCP's main purpose is to manage the risk that could arise if one counterparty is not able to make the required payments when they are due, i.e. defaults on the deal.

CCPs are commercial firms. There are currently about a dozen CCPs, all but one located in Europe or the USA, clearing interest rates, credit, equity and commodities OTC derivatives.

What is capitalisation of bank exposures to central counterparties (CCPs)?

It is the amount of capital that banks will be required to hold against their exposures to central counterparties.According to the existing regulatory framework, banks do not have to hold capital for these exposures provided that certain conditions are met. This will change with the upcoming legislative proposal in order to reflect the fact that exposures to central counterparties are not risk free. The proposal will suggest applying different risk weights depending on the type of the exposure the bank has vis-à-vis the central counterparty.

What is credit valuation adjustment?

Credit valuation adjustment (CVA) is an adjustment made by a bank to the market value of an OTC derivative contract to take into account credit risk of the counterparty, i.e. the risk that the credit quality of the counterparty deteriorates or that the counterparty in question defaults.

Specifically, it can be defined asthe difference between the 'hypothetical' value of the derivative transaction assuming a risk-free counterparty and the true value of the derivative transaction that takes into account the possibility of changes in creditworthiness of the counterparty (including the possibility of the counterparty's default). As such, in accounting terms, CVA is the "market value" of credit risk.

Why is CVA important?

The Basel Committee decided to introduce an explicit capital requirement for the CVA risk (i.e. a requirement for extra capital) after it was revealed that nearly two-thirds of the losses stemming from derivatives during the crisis were a direct consequence of the deterioration of the credit quality of the counterparty, and not necessarily triggered by the default of the counterparty, already covered by the existing regulatory framework.

The calibration of the capital charge for CVA risk was published by Basel in December 2010. The one outstanding issue is what to do in the event that a bank creates a valuation adjustment/provision for CVA risk (i.e. writes down some capital to take account of the risk) (i.e. "incurs CVA"), and how to recognise it in the respective capital treatment, i.e. how does the amount of the created valuation adjustment/written-off capital count towards the overall capital requirements to reflect the fact that this amount cannot be lost twice. Addressing this issue requires assessing how much credit banks should get for creating provisions for the CVA risk.